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Sunday, August 24, 2014

It is hard not to be cynical when you see charts like this one. It shows what appears to be a systematic relationship over the past 6 years between changes in the Fed share of marketable treasuries and PCE core inflation:

The figure indicates the Fed allows its share of marketable treasuries to change--by either engaging in LSAPs or refraining from doing so as the total share grows--so that core PCE inflation stays in the 1% to 2% corridor. Here is the scatterplot of this data:

Now this is just a reduced-form relationship, but it is highly suggestive and consistent with my claim from an earlier post that there really is no 2% target. Rather, there is a 2% ceiling to an inflation target corridor. As I showed in that post, the timings of the QE programs tend to line up with this view. The above chart provides further evidence.

P.S. For those observers who are so focused on endogenous money that they fail to see how a central bank can shape the medium-to-long run path of inflation recall what we discussed here and here. A brief excerpt:

Now to be clear, most money is inside money--money endogenously created by banks and other financial
firms--and the Fed only indirectly influences its creation. However, it does so in an important way
by shaping
the
macroeconomic environment in which money gets created. Consequently, it
can have a large influence on inside money creation. For the
same reason it can also influence how stable is the
velocity of money. By successfully stabilizing the expected growth path
of total dollar spending, the Fed will be causing this seesaw process [offsetting changes in the money supply and money velocity] to
work properly.

Friday, August 22, 2014

I recently gave a talk to the Financial Planning Association of Kentucky. The slides from the presentation are below and readers of this blog with be familiar with many of them. In case you are not familiar, below is the slide outline and where to go for more information. The audience asked many questions that led the discussion beyond what was presented on the slides, including the Triffin Dilemma for US treasuries, why the Fed likes core PCE, and what is holding back the recovery. It was a lively and fun discussion.

Slide Outline
(1) Monetary Policy Tightened During the Recession. See here, here,and here.
(2) The Fed Allowed the Money Supply to Collapse. See here, here, and chart to the right.
(3) The Fed Did Not Gobble Up the National Debt. See here and here.
(4) The Fed Did Not Artificially Lower Treasury Interest Rates. See here, here, and here.

It's a scary prospect, and a concern that's gotten
louder and louder over the past year. In economic circles, it goes by
the alliterative name of "secular stagnation." And it's a phrase that Fed watchers are likely to hear more and more in the months ahead.

Recent comments
by the vice chairman of the Federal Reserve, Stanley Fischer, indicate
questions within the central bank about whether the slow growth that has
followed the recent recession could reflect, or at least could
potentially morph into, longer-term issues within the economy. And while
Fischer avoided the phrase "secular stagnation" in his Monday speech,
Minneapolis Fed President Narayana Kocherlakota is planning to host a
November symposium that directly addresses the issue of secular
stagnation by name, CNBC has learned.

Actually, it is worse than Rosenberg reports. The FOMC projections that are available show a pronounced downward trend in the "longer run" forecast of the federal funds rate. This projection is the expected average value of the federal funds rate over the long run. In short, its the expected long-run netural federal funds rate. Its declining trend can be seen in the figure below which shows the average of each member's FOMC "longer-run"forecast for each meeting where projections are available:

I have a hard time believing the fundamentals warrant this downward revision in the long-run neutral interest rate. Where is the optimism? Clearly, the FOMC members need to drink an elixir of readings by Joel Mokyr, Erik Brynjfolsson and Andrea McAfee, and Marc Andreessen to beef up their technology optimism. And then they could follow it up with a Bill McBride treat of demographic optimism. And to wash it all down, they should finish with a John Cochrane cocktail of secular stagnation skepticism.

Update: I stand corrected. Stanley Fischer in his speech actually leaves open the possibility of strong productivity growth going forward. Good for him! Here is an excerpt and related footnote:

Possibly we are moving into a period of slower productivity growth--but I
for one continue to be amazed at the potential for improving the
quality of the lives of most people in the world that the IT explosion
has already revealed. Possibly, productivity could continue to rise in
line with its long-term historical average10

And here is footnote 10

For a fuller discussion, see, for example, Erik Brynjolfsson and Andrew McAfee (2011), Race
Against the Machine: How the Digital Revolution Is Accelerating
Innovation, Driving Productivity, and Irreversibly Transforming
Employment and the Economy (Lexington, Mass.: Digital Frontier Press); Erik Brynjolfsson and Andrew McAfee (2014), The Second Machine Age: Work, Progress, and Prosperity in a Time of Brilliant Technologies
(New York: W. W. Norton & Company); and Martin Neil Baily, James
Manyika, and Shalabh Gupta (2013), "U.S. Productivity Growth: An
Optimistic Perspective," International Productivity Monitor, no. 25 (Spring), pp. 3-12. See also Ben Bernanke (2013), "Economic Prospects for the Long Run," speech delivered at Bard College at Simon's Rock, Great Barrington, Mass., May 18.

There is a new VoxEU ebook on secular stagnation. The book is a collection of essays by many prominent economists, most of whom are proponents of secular stagnation. As readers know, I am not convinced that this problem lingers over the U.S. economy and have explained why at the Washington Post and on this blog. This latest book does nothing to ease my skepticism. Many of the authors continue to mismeasure the real interest rate and ignore what I see as important technology and demographic developments that undermine the case for secular stagnation. Let's review these key issues.

First, real interest rates adjusted for the risk premium have not been in a secular decline. Everyone from Larry Summers to Paul Krugman to Olivier Blanchard ignore this point in the book. They all claim that real interest rates have been trending down for decades. The editors of the book, Coen Teulings and Richard Baldwin, even claim that this development is the 'prima facie' evidence for secular stagnation. What they are doing wrong is only subtracting expected inflation from the observed nominal interest rate. They also need to subtract the risk premium to get the natural interest rate, the interest rate at the heart of the story. For it is the natural interest rate that is affected by expected growth of technology and the labor force.

This point can illustrated by looking at the 10-year treasury yield for the United States (these graphs were first used in my Washington Post piece). The figure below shows the 10-year nominal treasury yield along with its expected inflation and term premium. The former
is the annual average inflation rate expected over the next ten years, while the
latter is the risk premium on treasuries that increases with the holding period
of the security. The expected inflation series is constructed using data from
the Survey
of Professional Forecasters and the Livingston
Survey.The term premium is the average of the Kim-Wright
and Adrian,
Crump, and Moench estimates of the term premium.

Note that both the expected inflation and the term premium begin to grow
in the mid-1960s and peak in the early 1980s. From there, they both experience a secular decline. These developments track the increased uncertainty over the nominal anchor, inflation expectations, and economic policy that occurred during this time.
Many stories are given for why this happened--LBJ trying to do Vietnam
and the Great Society, beginning of the Bretton Woods System breakdown, Fed
using bad economic theory, etc.--but the big point is there was a big
policy break from the past of relative price stability and this shock affected both the risk premium and inflation expectations.

Proponents of secular stagnation only account for the expected inflation term. They subtract it from the observed nominal treasury yield and behold a declining trend in real interest rates is found starting around early 1980, as seen below.

But this is not the risk-free real interest rate, the one that best approximates the natural interest rate idea. To get that, the secular stagnationists need to also subtract the estimated risk premium. This measure, shown below, shows no clear declining trend but does show a stationary-like process that revolves around a mean just about 2%.

Now one could claim a new trend has set in over the last decade, but proving its a trend in this short of time is impossible. Moreover, there is a simpler answer: the deviations around the 2% mean are driven by the business cycle and we just happen to have gone through one of the worst in a long time. The figure below supports this view as it plots the CBO's output gap measure against the 10-year risk-free real interest rate:

To be clear, the 10-year real risk-free rate should be equal to the average
of the expected path of the short-term real risk-free rates over the same
time horizon. The first few years of this interest rate path are determined by the business
cycle, which explains the risk-free rate's correlation with the output
gap as noted above. The remaining years are shaped by expected growth of productivity and
labor force and that explain the roughly 2% trend. Proponents of secular stagnation are effectively claiming the long-term 2% trend is no more. I don't buy it because one, I think they are confusing the trend for the cycle, and two, technology and demographic developments are far better than commonly portrayed. That leads us to our next point.

Second, technology growth appears to be rapidly growing but getting harder to measure. This point has been made recently by Joel Mokyr in the Wall Street Journal and Erik Brynjfolsson and Andrea McAfee in The Second Machine Age: Work, Progress, and Prosperity in a Time of Brilliant Technologies. Their basic point is that the economy
is being radically transformed via smart machines and this will spur a period of great productivity growth, high returns to capital, and more investment. For example, imagine all the new infrastructure spending that will have to be done to support the increased use of driverless cars and trucks. Even over the past few decades there have been meaningful gains as illustrated by this hilarious spoof the show 24 being made in 1994. Noah Smith makes the case for big productivity gain even more recently. The secular stagnationists should take these developments more seriously.

Probably one reason these developments get overlooked is that they are hard to measure. As I noted in my Washington Post piece, a good example can be found in your smartphone. It contains many items you had to formerly purchase separately--books, newspapers, cameras, scanners, bank ATMs, voice recorders, radios, encyclopedias, GPS systems, maps, dictionaries, etc.--and were counted part of GDP. Now most are free and not a part of GDP. My sense is this is not a recent phenomenon, but has been going on for sometime as the economy has become more service orientated. Measuring productivity in the service sector is notoriously hard. And it is only going to get harder.

Here is a great illustration of this measurement problem. Tyler Cowen has made the case that there has been a Great Stagnation in innovation that explains the observed slowdown in productivity data. I looked at the John Fernald TFP data and found this troubling chart. It seemed to confirm the Great Stagnation theory. It showed a sharp break in trend TFP growth starting around 1973:

Tyler Cowen approved of the chart, but Noah Smith raised some good questions about it. He observed that the Fernald TFP data can be decomposed into TFP in investment production and TFP in consumption production. TFP in investment looks better than the overall TFP:

While that is interesting, what is really striking is the TFP in consumption. It has basically flatlined since the early 1970s and is what is driving the Great Stagnation. In the spirit of Tyler Cowen, let's call this segment "The Great Flattening."

The Great Flattening does not seem reasonable. Has productivity growth in consumption really been flat since the early 1970s? No meaningful gains at all? This does not pass the smell test, yet this is one of the best TFP measures. This suggest there are big measurement problems in consumption production. And I suspect they can be traced to the service sector. I suspect if these measurement problems were fixed there would be less support for secular stagnation (and maybe for the Great Stagnation view too).

Third, the demographic outlook is not as dire as the secular stagnationists make it out to be. Bill McBride has been noting for some time that the U.S. demographic outlook is improving as the largest cohort is now found in the Millenial age group. Matt Busigin also makes this point. Globally, the United Nations also forecasts that working-age populations in many parts of the world will grow through 2050. More labor growth implies a higher return to capital and more investment demand.

These are the reason I remain skeptical about secular stagnation and optimistic about future U.S. economic growth. Maybe the secular stagnation story makes sense for the Eurozone, but at a minimum the authors of this VoxEU book should be more cautious in their endorsement of it for the United States. My sense is that they are missing the forest for the trees.
They see a five-year slump, the zero lower bound,
and a gloomy outlook. From these few bad 'trees' they conclude the
entire forest has succumbed to the secular stagnation disease. The evidence above suggests they are wrong. They need to start looking closer at the forest.